Curing too much consumer debt

When I was a kid, I used to hate it when my doctor said, "This might pinch a little." In kid language, what he was really saying was, "Buckle up 'cuz this is going to really hurt!" Well folks, when it comes to curing the economy's consumer debt woes, I'm afraid "this might pinch a little." Here's what I mean.

An inevitable reckoning

If I use debt today to buy something I can't afford, I face an inevitable reckoning at some point in the future. The decision to borrow money today means I am automatically confronted with two choices tomorrow. Either I will consume less tomorrow in order to repay my borrowing, or I will need borrow more just to keep my consumption steady. Of course, if tomorrow I decide to expand my consumption even further, then I'll have to take on even more debt, a process which puts me even further behind the eight ball in the next future period. If my appetite to consume remains unchecked, this process will continue until my financial world collapses under the weight of my total debt.

That was the situation many people found themselves in last year. Some people described the 2008 debt crisis as if it were a massive tsunami surprising families in their sleep. In fact, it was no sudden tsunami at all. The debt crisis had been building for years, but the build up was so gradual that few noticed and others ignored how dangerous it had become. It was like boiling the proverbial frog.

Consumers retrench

All that has changed. Consumer credit is retrenching. In yesterday's release on consumer credit trends, the Federal Reserve reported that overall consumer credit has dropped nearly $119 billion since its peak in July 2008. During August 2009 it fell by $12 billion. $10 billion of the drop came from credit cards. With consumer spending accounting for almost 70 percent of U.S. economic activity (much of it fueld by the surging growth in credit cards), it is easy to see why consumer activity has been muted for the past two years.

We expect the retrenchment to continue. At least we hope it will. The future long-term health of our economy--the economy our children and grandchildren will inherit--requires it. However, the deleveraging of the economy will likely lead to several years of subpar economic growth as we pay back the irresponsible borrowings of the recent past. Unwinding our consumer debt carries at least five ramifications for the economy:

Financial markets will remain volatile as they come to grips with a slower growing economy.

Labor markets will remain shakey as companies resist hiring in the face of unreliable consumer demand.

Risk appetites will remain muted as investors perceive little reward for capital market risk. This will cause the cost of capital to be higher than it has been in the recent past. It will also make capital harder to come by at any price.

Economies and companies that rely on a consumer-led economy are going to be most vulnerable.

Politicians are going to feel political pressure to "do something." This pressure may lead to even greater intervention in the struggling economy spurring a further shift to more liberal political ideology. Unfortunately, increased government intervention likely to prolong the adjustment period.

Recommended response

How individuals and families respond to these changing realities will have a huge impact on their long-term financial health. We recommend four specific actions for weathering the storm:

Make sure you have a comprehensive financial plan in place. It should be updated at least once a year to make sure it stays relevant. A comprehensive financial plan will help you clarify your goals, understand your current situation better and outline possible future contingencies.

Make sure you stay with the plan. During times of financial calm, it is easy to forget about the discipline your plan requires; during times of financial crisis, it may seem reasonable to forget the plan and to run for cover. Both reactions, though understandable, are traps. Crises are rarely as bad as pundits will lead you to believe. Good times never last forever. Your plan is there to help you avoid traps, so stay with the plan.

Use periods personal financial calm to pay down your debt and strengthen your financial reserves. Start by paying off your credit cards, then move to pay off car loans and other debt including home equity loans, and then pay off your mortgage. You should also build an emergency reserve equal to about six months of your living expenses. Depending on where you are right now, these recommendations may seem like I'm telling you to climb Mount Everest. Don't worry--many people have been able to do this and you can too. If you want more encouragement, check out Dave Ramsey's book The Total Money Makeover.

Invest in conservative, well-diversified public investments. There is always a lot of hype in the investment world. In my experience, hype doesn't pay. On the other hand, a properly structured portfolio using conservative, public investments seldom goes wrong. You will still experience gyrations in value as the markets get knocked around, but if the portfolio is properly structured, you should be able to weather the gyrations with confidence.

Conclusion

The world is changing. Consumers are at a point where they have to retrench and pay down debt. This retrenchment will lead to significant change and uncertainty in the world. Though change can be disconcerting, or even frightening, those who are well-prepared and properly positioned for it, can benefit from it.